Don’t play with FIRE; get professional retirement advice
I’m not saying you should do this. In fact, very probably, you shouldn’t.
In discussing early retirement plans with my buddy Justin recently, however, I learned about penalty-free ways of accessing retirement accounts early. This column is in the spirit of learning about obscure financial planning tips relevant to 1 in 1,000 people.
If during your 20s, 30s and 40s, you diligently socked away money in a tax-advantaged account, how would you access these funds for your early retirement?
Justin mentioned two techniques known to FIRE Movement adherents for accessing retirement account funds early, without penalty. One is known as the “72(t) exemption.” The other is “building a five-year Roth conversion ladder.” I’ll take them one at a time.
The 72(t) exemption allows a person younger than 59 ½ (the ordinary nonpenalty retirement age) to lock in a fixed annual withdrawal amount from an retirement account — as long as that withdrawal continues until age 59 ½ and for at least five years.
The amount withdrawn may be determined by an IRS table of “expected remaining life.” That’s the same table used for typical required minimum distributions from retirement accounts after age 70 ½. Or it could be determined by two other allowable methods, which fix an annual withdrawal rate based on either “annuitizing” or “amortizing” your account balances in an even, formulaic way.
The bummer of this technique is that it’s inflexible. Once you start retirement account withdrawals under the 72(t) exemption, you can’t stop until age 59 ½, even if your life circumstances change. In addition, any account that goes into 72(t) mode cannot be contributed to anymore. It’s locked. And your withdrawal amounts are locked in.
Ben Gurwitz, certified financial planner and principal of San Antonio-based Financial Life Advisors, a fee-only financial planning firm, likens the 72(t) choice to “a straitjacket.”
He also says he has never had a client choose the 72(t) option. As he says, “Once you turn this thing on, you can’t turn it off.”
The second FIRE technique for accessing retirement account money early — the “five-year Roth conversion ladder” — is a lot more reasonable and a lot more flexible.
As a reminder, Roth retirement account contributions are taxed upfront but allow for tax-free withdrawals in retirement.
Because Roth money already has been taxed as income, the rules are a bit more relaxed for how and when withdrawals can be made.
One semi-relaxed rule is that five years after converting funds from a traditional 401(k) to a Roth account, the Roth funds may be withdrawn penalty-free, even before age 59 ½. You are required to pay taxes on 401(k) funds to make the conversion, but then the Roth money is available tax-free in the future. And because of larger annual contribution limits, it’s easier and more plausible to build up a sizable nest egg in a 401(k) than in a Roth IRA.
Maybe an example would help. You’re 45 years old. You plan to retire at 50. And you need the funds in your $250,000 401(k), at least until you qualify, let’s say, for a combination of Social Security and a pension at age 59 ½.
You begin to construct your “Roth conversion ladder” by converting $25,000 of your traditional 401(k) into a Roth IRA at age 45. You owe some income taxes on that conversion. You continue to convert $25,000 per year, every year, for the next 10 years, until the original traditional 401(k) is depleted.
The goal is that by the time you hit 50 — early retirement age — you can withdraw $25,000 from the Roth account without incurring any early-retirement penalty. By converting $25,000 each year starting at age 45, you should have $25,000 (or more after investment gains) available as tax-free income annually beginning at age 50.
As long as your conversion was done at least five years prior, you can withdraw Roth converted amounts tax-free and penalty-free. That’s the basis for the five-year Roth conversion ladder strategy for early retirement folks.
Gurwitz said this is a more flexible approach to early-retirement planning, and a technique that in no way restricts future income or decisions. If one decides to not retire at 50, besides having paid taxes, there’s no particular downside to having converted traditional 401(k) retirement funds into a Roth.
Gurwitz agreed with me, however, that the concept of FIRE itself may be the problem, in so far as people are eager to quit work. The “work is just a means to an end,” approach maybe misses the bigger picture about the value of work in our lives, he said. “They (FIRE adherents) are shooting at the wrong thing.”
Another problem he sees,is people trying to do this entirely on their own. Planning for retirement, and especially early retirement, can be complicated.
But the kind of people who passionately read FIRE blogs are precisely the kind of people uninterested in paying a financial planner.
Gurwitz cautioned against that do-it-yourself approach.
“If they can’t afford to see a professional, they probably can’t afford to be financially independent and retire early,” he said.
So, as Smokey Bear might say, don’t play with matches, kids, and seek professional help before you start your FIRE.